Diving Off the Fiscal Cliff

December 3, 2012

Washington continues to debate what course of action it should take in response to the nearing fiscal cliff. If no action is taken by the beginning of 2013, there will be roughly $500 billion in tax increases and about $100 billion in cuts to government spending, says Stephen J. Entin of the Tax Foundation.

The biggest worry that many have about the fiscal cliff is the impact it will have on the long-term production of goods and services in the United States. As taxes rise, there is less of an incentive to produce various good and services. In turn, many jobs will be lost. Moreover, workers have less capital to work with, which reduces productivity gains and workers' wages.

Since tax rates go up for people and businesses, there is less incentive to acquire larger facilities, invest in companies, or even work longer hours. Entin modeled the effect that individual provisions of the tax increases would have on the economy:

Increased rates on capital gains and dividends would lower gross domestic product (GDP) by more than 6 percent. Moreover, these tax rate increases would reduce labor income by 6 percent, as well as reduce the hourly wage by about 5.3 percent for those working.

Increasing the rates on estates and gifts loses the government about $18.5 billion.

Lifting marginal tax rates will cost the economy $2.20 in lost income for every $1 of new tax revenue. Moreover, GDP and labor income will be reduced by 1.2 percent.

There are several effects the fiscal cliff will have on the economy over time.

The slowdown in investment and job growth is expected to be immediate once the tax increases and spending cuts kick in.

Over time, property values of existing buildings will go down.

In five years, about two-thirds of capital formation will experience a shortfall.

Similarly, the first five years will see a reduction in the growth rate of the GDP and employment by 1 percent and 1.5 percent a year, respectively.